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An Economic Examination of Collateralization in Different Financial Markets

by Tim Xiao of Canadian Imperial Bank of Commerce (CIBC), Toronto, Canada

May 1, 2013

Abstract: This paper attempts to assess the economic significance and implications of collateralization in different financial markets, which is essentially a matter of theoretical justification and empirical verification. We present a comprehensive theoretical framework that allows for collateralization adhering to bankruptcy laws. As such, the model can back out differences in asset prices due to collateralized counterparty risk. This framework is very useful for pricing outstanding defaultable financial contracts. By using a unique data set, we are able to achieve a clean decomposition of prices into their credit risk factors. We find empirical evidence that counterparty risk is not overly important in credit-related spreads. Only the joint effects of collateralization and credit risk can sufficiently explain unsecured credit costs. This finding suggests that failure to properly account for collateralization may result in significant mispricing of financial contracts. We also analyze the difference between cleared and OTC markets.

JEL Classification: E44, G12, G24, G32, G33, G18, G28.

Keywords: unilateral/bilateral collateralization, partial/full/over collateralization, asset pricing, plumbing of the financial system, swap premium spread, OTC/cleared/listed financial markets.

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